The July FOMC minutes showed that a rising number of participants were willing to raise rates sooner.
Though some point out that hawks have more of a voice in the minutes than on the committee — since the voting members of the Federal Open Market Committee (FOMC) have a dovish rather than hawkish slant.
But of course we all remember the taper tantrum last June — when the Fed suggested that rates could rise sooner than expected, causing bond prices to fall.
With that in mind, we spoke with Meg McClellan at JP Morgan Asset Management about the worst case scenario for the bond market and the riskiest thing that bond investors are doing right now.
In this low interest rate environment, McClellan thinks “the dramatic reach for yield” is a major cause for concern. And in the backdrop of a low rate environment, and interest rate risk, she says the riskiest thing people can do is have a short time horizon.
“You can’t have a short time horizon and you can’t be spooked out of the market during times like that, of the things you have conviction in,” McClellan told Business Insider.
Here are some of the highlights from the interview:
- A “dramatic reach for yield,” is the biggest cause for concern.
- “What I don’t like to see is for people to reach for yield and think they have got diversification, because they have got high yield munis, because they own high yield credit, because they own high yield preferreds, because they’re all going to act a lot like equities.”
- Investors are moving away from benchmark driven investments.
- “You certainly don’t want to buy riskier assets with a shorter time horizon, like you would with a longer time horizon.”
- Bonds would be upset by a rapid rise in wage inflation which in turn would cause the Fed to act quickly.
Business Insider: Where are clients taking too much risk when it comes to bonds?
Meg McClellan: “It’s a really interesting question because it number one, depends on the type of client, and number two, depends on your time horizon and your outcome needed in a bond investment. For example if you’re doing an asset liability match and you’re looking specifically at rates or investment grade corporates like a pension fund would, you would get a different risk because you would get an offsetting liability, whereas for individual investor and you’re desperately seeking yield and you’re buying lots and lots of high yielding risky assets that might have more risk to them than you would normally take, that’s a different story.
So I think it really depends on the investor, and the outcome that the investor is trying to seek, along with their time horizon. You certainly don’t want to buy riskier assets with a shorter time horizon, like you would with a longer time horizon. I hate to answer a question with it depends, but dealing with investors from sovereign wealth funds to individuals saving for retirement really does depend.”
BI: In terms of individual investors then what are you seeing?
MM: “When we look at the mutual fund flows coming into JP Morgan we break this down not just by the United States, but also European and Asian mutual fund flows, and that gives us a pretty good look at what retail investors are doing. So the vast majority of inflows we’ve seen year-to-date continue to be into unconstrained and absolute return funds. We talked about this at the press breakfast, it’s the idea that a benchmark rewards bad behaviour. So when you have someone traditionally tied to a benchmark you’re rewarding the issuers who are issuing the most debt, at increasingly longer durations, at increasingly lower yields and that’s not necessarily who you want to lend to in this environment.
So we’re seeing investors continue to move away from that benchmark driven investment, to provide some diversification in their portfolios, whether that’s an absolute return type of investment, which is a complement to traditional core bond investing, so something that’s meant to protect a portfolio; or whether that’s a constrained investment in credit, in global credit, in global bonds for example, that would be more high risk, that would typically sit in more of an extended credit or a riskier part of your portfolio. In multiple locations we’re seeing clients, as individuals, move away from benchmark.
Where we’re seeing retail clients sell across the board is traditional core bond investments, where they felt like last year was kind of a wake-up call in terms of interest rate risk — the global aggregate, it’s the U.S. aggregate — and so that’s a global theme that we’re seeing. And in Asia specifically, we’re continuing to see interest in global and U.S. high yield. In Europe, we’ve seen a big pick-up in emerging market interest. And Europe tends to be ahead of the curve in terms of global flows, and we’ve seen a good pick up into the EM debt space, that’s in the first quarter, as it looked relatively cheap to other higher yielding markets.
BI: What would concern you the most when you look at a client’s portfolio?
MM: I think what would concern me the most is, in a lot of client portfolios you see this dramatic reach for yield. You see people who are doing things like layering on preferreds with high yield, with maybe not so much emerging market corporates in the U.S., but they will try to find the highest yielding funds that they find can out there just to try and get some income. And what you’re doing to get that income and that yield, is you’re going into riskier and riskier places. And certainly we saw that in the municipal market since the beginning of last year, where they were piling on yield, and they were piling into higher yielding muni bond funds and some of those had, as we know, a lot of exposure to Puerto Rico which has turned out be pretty sloppy.
What I don’t like to see is for people to reach for yield and think they have got diversification, because they have got high yield munis, because they own high yield credit, because they own high yield preferreds, because they’re all going to act a lot like equities. And they will have a lot more correlation as risk assets.
So just because you own a lot of risk in different types of asset classes doesn’t mean those things aren’t correlated. You still need to own some sort of an anchor in your portfolio, and you can do that through a number of different things, but not everything in your portfolio should behave alike when things get tough. So I would really urge people to look at the historic behaviour of the asset classes they’re investing in and don’t think you’re getting diversification just because you’re getting high yield from a lot of different places.
BI: What would be the worst case scenario for the bond market?
MM: The worst case scenario is something that the Fed is extremely aware of, is really looking at the rate of wage inflation. We’ve seen unemployment come down pretty dramatically, even faster than growth accelerates, there is some concern that the Fed may be behind the curve on inflation. But what I think the Fed is really watching is the wage inflation number. So if you look at wage inflation now, Janet Yellen thinks 3-4% is a normal range, so if you start to see that wage inflation pick up that’s what’s really going to drive up consumer prices very quickly, and the Fed’s going to act quickly. And we know that the Fed has to act quickly in a way that you know, we’ve had this really good strong pretty consistent messaging so far. That quick sharp movement would be something that would upset the bonds pretty quickly. We’re watching the wage inflation number pretty closely, but again we’re at the point in the cycle where both price inflation and wage inflation, are rising very gradually, so we don’t see a threat right now but more of a confirmation of recovery, but certainly that’s something you want to watch very closely.
BI: What would need to happen for us to not see a disorderly sell-off in the bond market. Could we have a repeat of the 2013 taper tantrum?
MM: During the taper tantrum we saw a short, sharp spike in interest rate. And all of a sudden, everyone that had high yield, realised that it had interest rate risk to it. So they started to sell high yield and you saw those gap out. Then there was concern about the spillover effect in to emerging markets and you started to see those yields and spreads gap it, and you saw a viscous cycle of higher rates beginning higher spreads etc. If you ultimately looked at an investment over the course of the year, instead of just looking at that period of three or four months with the taper tantrum, you saw positive returns in high yield, you saw positive returns in the high yield that people were so worried about in June becoming an underperforming asset class. There was a panic sell in the higher yielding asset classes as rates rose, but ultimately the carry, the yield of that asset class, plus the recovery of the spread compression, people sort of normalized the higher rate environment, that overreaction reversed and ultimately ended up with a positive year-over-year return.
So this goes back to your first question, what is the riskiest thing people are doing right now? Well if your time horizon is a month, two months, three months, and you invest right before the taper tantrum that’s bad. However, if you’ve got a one year holding period, even if rates fell off a 100 basis points again, you’re probably not going to see the credit spread compression you saw last time, but certainly carry on higher yielding assets makes up for quite a bit of that spike in interest rate.
There can be short periods of volatility, and we expect short periods of volatility, given the declining liquidity, but you know again for people that can buy and hold, and you have to choose your credits wisely, and you can choose credits that will recover from that type of rate movement, that’s not a terrible thing for a buy and hold, or longer term investor. You can’t have a short time horizon and you can’t be spooked out of the market during times like that, of the things you have conviction in.
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